HXS ETF vs Conventional S&P 500 ETFs in a Corporation

The S&P 500 holds 500 leading US large-cap companies, representing about 80% of the US market. Canadian-listed S&P 500 ETFs are a convenient and low-cost way in most of the US market. For investors using a CCPC (private corporation) to invest, the dividends from conventional S&P 500 ETFs have an extra tax drag due to foreign withholding taxes. Plus, the usual tax inefficiencies of passive income in a corporation. Horizons’ corporate class HXS ETF bypasses those tax issues.

When functioning as intended, the HXS ETF’s corp class structure converts the income to capital gains. That bypasses those FWT and passive income issues. However, it comes at the cost of a higher fee and some extra risks. Plus, more complexity than an asset allocation ETF. Would it be worth considering for your corporate investing? Learn more and decide for yourself.

Corporate Tax Efficiency

I will be brief, but corporate tax on investment income is impacted by the income type, the total corporate income, and how it is paid out to shareholders. I have described the details of how that works and different corporate tax efficiency states in previous posts for interest and eligible dividend income.

Foreign dividends are treated similarly to interest income. With the added wrinkle of an increased tax drag from how foreign withholding taxes are treated in a CCPC. More on that in the next section. First, the main tax efficiency states that I will model for the HXS ETF vs its competitors are listed below.

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Efficient CCPC

An efficiently function corporation is flowing the passive income through as dividends. Those would be dividends required by the owners to live off of. So, not an extra cost. The amount of dividends required is enough to release the RDTOH refund to the corporation.

The aggregate investment income from all passive income sources coupled to the corporation’s active income is also below the active-passive income threshold.

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nRDTOH Trapping

If the nRDTOH generated by the corporation’s various sources of passive income is more than what is released by the dividends required by the owner to live on, then there is a dilemma. At low personal marginal tax rates, it could make sense to give extra dividends. If the personal taxes are much less than the corporate refund. However, if the refund is less than the personal taxes paid, then the nRDTOH is essentially trapped in the corporation. Until the dividends are needed personally.

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Over the Passive Income Limits

If a corporation has more than $50K of passive income, its small business deduction (SBD) threshold will shrink the following year. The SBD threshold starts at $500K and shrinks at a 5:1 clip. So, all of the corporation’s active income gets taxed at the higher general corporate tax rate if there was $150K of passive income the previous fiscal year. That represents a 60-75% tax bump on corporate income.

However, if the owners are able to use the extra eligible dividends that the corp gets to pay due to the higher corporate tax rate, that attenuates the impact. Higher corporate tax and a lower personal tax rate. In most provinces, that is still a big tax bump. In Ontario and NB, there is an anomaly that makes the personal savings greater than the tax bump (a good thing if you are spending the money personally).

If the owners do not use the excess eligible dividends, then they are stuck with the 60-75% tax bump now. They may get some personal savings down the road when they use the eligible dividends. The net impact, even then, is a significant tax bump.

US Foreign Withholding Tax in a CCPC

The United States collects a 15% FWT on dividend income paid to foreigners from companies or ETFs domiciled there. Canada has a tax treaty with the US. So, when Canadian taxes are paid, the FWT already collected functions as a tax credit. Unfortunately, in corporate taxation, there are also adjustments made that reduce the amount of nRDTOH.

The net effect is a higher total tax rate. The dividend is taxed at the usual high rate on passive income upfront. About 50%. Instead of 30.67% going to the nRDTOH account, only 18.77% is credited to the nRDTOH for US dividend income. Tax integration is the concept that the total personal and corporate tax paid should be equal to earning the income directly. The personal dividend tax credit on non-eligible dividends is supposed to account for the corporate taxes paid. That system is already imperfect and does not favor corporations. It is based on the 30.67% refund. So, with 18.77%, tax integration is even more punitive for US dividend income.

For example, a $10K US dividend flowing through an Ontario corporation into personal hands has a total tax rate of 64.15%. If taken directly, in the top Ontario tax bracket, the comparable total tax rate would be 53.53%. That is a 10.62% “imperfection”. The HXS ETF uses a total return swap contract. So, it doesn’t collect US dividends and bypasses the problem entirely.

Canadian-Listed S&P 500 ETFs

Canadian-listed ETFs are used for simplicity. In a corporate account, there is no advantage to using US-listed versions. There are some US-listed ETFs with an MER as low as 0.03%/yr. However, with the MER of the Canadian versions being 0.09%/yr, it likely isn’t worth the hassle. Even using Norbert’s gambit, you may lose more on currency conversions. I will only use ETFs that are not $CAD-hedged. Not only does $CAD-hedging cause fee drag, but the $USD tends to be seen as a safe haven relative to the $CAD. So, it moves counter to equity markets, and $CAD-hedging increases volatility without an increase in long-term expected returns.

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Conventional ETFs: ZSP, VFV, XUS

Each of the big Canadian ETF providers has a similar S&P 500 ETF. BMO has ZSP, Vanguard has VFV, and Blackrock iShares has XUS. They all have the MER of 0.09%/yr as mentioned. They are conventional trust structure ETFs and pay out dividends. The S&P 500 yield varies depending on the dividends and market price fluctuations. For the simulation, I will use a yield of 2% for the index. The ETFs would pay that minus their MER and FWT collected. That FWT is credited as per the previous section. So, dividends of 1.91%/yr would be subjected to corporate taxation.

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Corporate Class ETF: HXS

Horizons’ HXS covers the total return of the S&P 500. As part of their corporate class family of funds, it is not expected to make distributions. However, if there were net income in Horizons’ fund corporation, then there would be an embedded tax that would lower the unit value. They still have a significant loss pool, but it bears watching.

Horizons uses a swap contract to replicate the S&P 500 instead of holding the stocks directly. That has the advantage of no currency conversions, no foreign withholding taxes, and no taxable income. Just the total return as capital gains. It also offers potential control of when to settle swaps and manage income for Horizons’ fund corporation.

Horizons may need to settle swaps if there is too much counter-party risk. The counter-party is National Bank and the counter-party exposure is currently 32%. That is subjectively moderate but it could jump if markets rocket. The swaps also come at a cost of up to 0.30%/yr. That is a drag on top of the MER of 0.11%/yr. So, I will use 0.41%/yr fee drag for the model.

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The S&P 500 vs Broader US Market Index

I am comparing HXS vs other S&P 500 ETFs. That is to have an apples-to-apples comparison. However, the other question to ask is whether that is the best way to get US market exposure. The S&P 500 is going to be underweight mid and small-cap companies. Historically, smaller size may have an increased expected return over long time periods. However, the S&P 500 also overweights other positive factors like value, profitability, and conservative investment. Overall, it is a wash for VOO (SP500 ETF) vs ITOT (US Total Market ETF). So, an S&P 500 ETF seems like a reasonable option to get US market exposure. Even though it isn’t the total market.

HXS ETF in an Efficient Corporation

When bought and held, the only tax drag on a conventional ETF is from the dividend income. The capital gains are only taxed when sold. So, for the modeling, I am only comparing the tax drag on income. For HXS, those dividends would be converted to capital gains. Whatever additional capital gains are made by the S&P 500 would add the same value to either ETF and I will ignore that for the comparisons.

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When Bought & Held

During the years that our ETFs are bought and held, HXS has a slight growth advantage of ~0.28%/yr. There is no corporate tax paid for HXS, but it has more fee drag relative to its conventional counterparts. This is shown for Ontario but would be similar across provinces.

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When the HXS ETF is Sold & The Capital Gains Realized

Unrealized capital gains are only tax deferral. The income that was converted to a capital gain in the corp class ETF eventually gets taxed when it is sold and realized. Whether that is an advantage or not depends on the current vs future tax rates.

For the model, I will use the top marginal bracket now and in the future. However, if the future personal tax bracket were lower, the corp class ETF would have a larger advantage. The personal tax on the non-eligible dividends required to refund the nRDOTH would be less. The other way that the capital gains from the corporate class may have an advantage is if the capital dividend account (CDA) is used.

As I detailed in the previous post on HXCN, a capital dividend could be used instead of salary or non-eligible dividends. That would require less money moved out of the corporation for the same after-tax personal dollars. A boost to corporate tax deferral. However, that requires enough capital gains to justify the accounting costs that range from zero to thousands of dollars. So, portfolio size matters in the sense that there need to be enough gains to harvest them effectively.

If you sell for some reason, but cannot use the CDA, then the HXS ETF has a miniscule 0.12% advantage on the corporate fee and tax drag. However, if able to use the capital gain as part of a capital dividend, then there is a significant advantage. As high as 0.97% if it is displacing salary or 0.70% if it is displacing non-eligible dividends for personal compensation. For those over the age of 40, you can click on the chart below to magnify it. I need to.

HXS ETF To Avoid RDTOH Trapping

If the corporation has more passive income than it is dispensing as dividends to release the refundable taxes, then the RDTOH may become trapped until it pays more dividends out. That means a tax drag of ~50% that isn’t attenuated by the 18.77% refund. In that situation, HXS has a larger advantage. The unrealized capital gain avoids the issue and gives HXS a 0.64%/yr advantage over its peers.

As mentioned before, that isn’t the end of the story. The gains must be realized and taxes paid at some point. That can be an advantage if the CDA is used. However, let’s assume that you don’t want to displace the non-eligible dividend income with a capital dividend. Less dividends would simply exacerbate the RDTOH trapping. When the income flows through the HXS ETF as a capital gain without using the CDA, it still has a slight 0.26% advantage net of fees and taxes.

HXS & Corporate Passive Income Limits

If a CCPC is running afoul of the passive income limits, that is when a corporate class fund, like the HXS ETF, has the chance to really shine. The advantage may be less decisive in Ontario and New Brunswick due to their not mirroring the Federal tax grab. So, I will present the data for both BC and Ontario to illustrate.

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Over the limit & not realizing the capital gain

If a corporation owner has a large active and passive income that gets the tax bump, they can attenuate some of that if they are also big spenders. The higher corporate tax is partially offset by the personal tax savings from using the GRIP generated. GRIP allows the corporation to pay more lightly taxed eligible dividends. Still, it is a net tax increase.

So, having a corporate class ETF with no income or realized gains has an advantage in BC and most provinces. Whether you can use the extra GRIP or not. It will be larger where the tax integration is less favorable for general corporations.

For Ontario, the advantage is minuscule (0.07%) if using the extra eligible dividends instead of non-eligible ones. In contrast, if you don’t need the personal cash flow or don’t have non-eligible dividends to displace, HXS has a 0.95%/yr advantage.

In New Brunswick, the conventional ETFs actually have a 0.36%/yr advantage if using the extra eligible dividends instead of regular ones (data not shown). However, HXS still has a 0.90%/yr edge if you cannot take advantage of that (data not shown).

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Over the passive income limit & harvesting gains

Most incorporated business owners with a “too much passive income problem” also have a large portfolio. There may be enough gains in the portfolio as a whole each year to harvest them and pay out capital dividends. If that is the case, then HXS is great. It should be a capital gain machine relative to a conventional ETF. In BC and most provinces, there is a 0.1-1.6% advantage for HXS ETF using the CDA depending on whether the CCPC can keep its GRIP flowing.

If unable to use the CDA effectively, then conventional ETFs have the advantage if you are able to spend the eligible dividends from the corporate tax bump. However, it is still ~1% if you cannot.

In Ontario, there is still a 0.2-1.1% advantage for flowing the capital dividends through via HXS. Even with the funky tax anomaly. The anomaly in NB is so egregious that the conventional ETFs win there, as long as you can use the extra eligible dividends to your advantage [data not shown]. If it is not cost-effective to use the CDA and you realize capital gains, then a conventional ETF is better if you are using the extra eligible dividends and HXS has a modest ~0.5% advantage if you cannot.

When Could the HXS ETF Be Worth It?

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HXS ETF vs conventional ETFs in an efficient smallish corp

HXS has a minor advantage over its conventional peers when bought and held by a corporation that is efficiently keeping the RDTOH flowing. That is likely most small private corporations. Whether the ~0.3%/yr advantage is worth the extra risk of using a more complex structure is debatable.

In the future, if you were to sell the HXS and flow through the capital dividend, that would be a larger potential advantage. That would require some significant capital gains in your corporate account to make it worthwhile though. The gains could be from the HXS ETF’s “converted income” plus the index’s regular capital gains. Plus, other ETFs.

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CCPC with “too much” passive income

Where HXS has the chance to shine is in a CCPC that has a high level of passive income. The advantage of avoiding RDTOH trapping (~0.65%/yr) is significant. It is fairly unusual for that to happen unless it is a large corporation with very low-spending owners. The more common tax inefficiency would be a run-in with the passive income limits. Still, that usually happens with a larger CCPC that also has a high active income. In that situation, avoiding passive income with HXS would offer a 1-2%/yr advantage in most provinces. Huge. The possible exceptions are Ontario and New Brunswick as long as you are spending enough to benefit from extra eligible dividends.

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HXS ETF for tax planning in a corporation generating large capital gains

The other way that HXS and the other corporate class ETFs can be beneficial in a larger corporation is by adding capital gains to the CDA. If you have enough capital gains across your corporately held ETFs, then a capital gains harvest could boost tax deferral. It does that by enabling a tax-free capital dividend election instead of having to pay out as much salary and regular dividends to get the same after-tax personal cash flow. I say that this is more beneficial to a larger corporation because there are accounting fees and you’d need enough capital gains to make the cost worthwhile.